Chapter 6: Inventory
Perspective and Issues
The accounting for inventories is a major consideration for many entities because of its significance on both the income statement (cost of goods sold) and the balance sheet. Inventories are defined by IAS 2 as items that are
held for sale in the ordinary course of business; in the process of production for such sale; or in the form of materials or supplies to be consumed in the production process or in the rendering of services.
The complexity of accounting for inventories arises from several factors.
1. The high volume of activity (or turnover) in the account
2. The various cost flow alternatives that are acceptable
3. The classification of inventories
There are two types of entities for which the accounting for inventories must be considered. The merchandising entity (generally, a retailer or wholesaler) has a single inventory account, usually entitled merchandise inventory. These are goods on hand that are purchased for resale. The other type of entity is the manufacturer, which generally has three types of inventory: (1) raw materials, (2) work in process, and (3) finished goods. Raw materials inventory represents the goods purchased that will act as inputs in the production process leading to the finished product. Work in process (WIP) consists of the goods entered into production but not yet completed. Finished goods inventory is the completed product that is on hand awaiting sale.
In the case of either type of entity the same basic questions need to be resolved.
1. At what point in time should the items be included in inventory (ownership)?
2. What costs incurred should be included in the valuation of inventories?
3. What cost flow assumption should be used?
4. At what value should inventories be reported (net realizable value)?
The standard that addresses these questions is IAS 2, which has been revised several times since it
was first promulgated. IAS 2 discusses the definition, valuation, and classification of inventory. Over the years, the principal objective of the IASB in making amendments to this standard has been to reduce alternatives for the measurement of the carrying value of inventories. Most recently, LIFO costing has been eliminated as an acceptable pricing method.
The international accounting standards tend to be “principles-based” (as opposed to being “rules-based”), and for that reason practical application guidance contained in IAS 2 is not as comprehensive as it is under various national GAAP, such as that in the US. The materials in the body of this chapter essentially reflect the level of guidance provided under IAS 2. To supplement this material, the Appendix to this chapter contains additional guidance from other sources (specifically, from US GAAP), which provides a basis for comparing the treatment accorded to this subject in other jurisdictions.
Under the provisions of IAS 2, before its most recent revision, the first-in, first-out (FIFO) and weighted-average cost methods were defined as “benchmark treatments” with the last-in, first-out (LIFO) method cast as the “allowed alternative treatments.” Since IFRS went to some length to avoid naming certain methods as being preferred or recommended (hence the term “benchmark,” which was deemed to be somewhat more neutral, although the connotation was clearly that these were to be preferred), it is fair to say that all three methods were acceptable under IAS 2, prior to its recent revision.